MAC3761 - Selected Accounting & Financial Management Techniques-study-summary-notes.

MAC3761 - Selected Accounting & Financial Management Techniques-study-summary-notes. TOPIC 1 Cost Objects A cost object is any activity for which a separate measurement of costs is desired. In other words, if the users of accounting information want to know the cost of something, this something is called a cost object. Examples of cost objects include the cost of a product, the cost of rendering a service to a bank customer or hospital patient, the cost of operating a particular department or sales territory or indeed anything for which one wants to measure the cost of resources used. We shall see that the cost collection system typically accounts for costs in two broad stages: 1. It accumulates costs by classifying them into certain categories such as by type of expense (e.g. direct labour, direct materials and indirect costs) or by cost behaviour (such as fixed and variable costs). 2. It then assigns these costs to cost objects. In this chapter we shall focus on the following cost terms and concepts:  direct and indirect costs;  period and product costs;  cost behaviour in relation to volume of activity;  relevant and irrelevant costs;  avoidable and unavoidable costs;  sunk costs;  opportunity costs;  incremental and marginal costs. Manufacturing, Merchandising and Service Organizations To provide a better understanding of how different cost terms are used in organizations it is appropriate to describe the major features of activities undertaken in the manufacturing, merchandising and service organizations. Manufacturing organizations purchase raw materials from suppliers and convert these materials into tangible products through the use of labour and capital inputs (e.g. plant and machinery). This process results in manufacturing organizations having the following types of inventories:  Raw material inventories consisting of purchased raw materials in stock awaiting use in the manufacturing process.  Work in progress inventory (also called work in process) consisting of partially complete products awaiting completion.  Finished goods inventory consisting of fully completed products that have not yet been sold. Merchandising companies such as supermarkets, retail departmental stores and wholesalers sell tangible products that they have previously purchased in the same basic form from suppliers. Therefore they have only finished goods inventories. Service organizations such as accounting firms, insurance companies, advertising agencies and hospitals provide tasks or activities for customers. A major feature of service organizations is that they provide perishable services that cannot be stored for future use. Therefore service organizations do not have finished goods inventory but some service organizations do have work in process. For example, a firm of lawyers may have clients whose work is partially complete at the end of the accounting period. S - The Marketplace to Buy and Sell your Study Material Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material Direct and Indirect Costs Direct materials Direct labour Indirect costs Distinguishing between direct and indirect costs Assigning direct and indirect costs to cost objects Costs that are assigned to cost objects can be divided into two broad categories – direct and indirect costs. Both categories can be further divided into direct and indirect materials and direct and indirect labour costs. Direct materials Direct material costs represent those material costs that can be specifically and exclusively identified with a particular cost object. In manufacturing organizations where the cost object is a product, physical observation can be used to measure the quantity consumed by each individual product and the cost of direct materials can be directly charged to them. In other words, direct materials become part of a physical product. For example, wood used in the manufacture of different types of furniture can be directly identified with each specific type of furniture such as chairs, tables and bookcases. The term direct material is normally not applicable to merchandising and service organizations. The equivalent term in a merchandising organization is the purchase cost of the items that are for resale. For example, with a departmental store where the cost object is a department (e.g. televisions and DVD players, computers, clothing and furniture departments) the purchase cost of the goods from the suppliers will be directly charged to the appropriate department that resells the goods. Some service organizations do purchase materials or parts to provide a service. For example, a garage may purchase parts for vehicle repairs. These parts can be identified with the repair of each customer's vehicle (i.e. the cost object) and thus are equivalent to direct materials. Direct labour Direct labour costs are those labour costs that can be specifically and exclusively identified with a particular cost object. Physical observation can be used to measure the quantity of labour used to produce a specific product or provide a service. The direct labour cost in producing a product includes the cost of converting the raw materials into a product, such as the costs of the machine operatives engaged in the production process in the manufacture of televisions. The direct labour cost used to provide a service includes the labour costs in providing a service that can be specifically identified with an individual client or with a specific instance of service. The direct labour costs for a departmental store are the labour costs of the staff that can be attributed specifically to a department. Indirect costs Indirect costs cannot be identified specifically and exclusively with a given cost object. They consist of indirect labour, materials and expenses. In a manufacturing organization where products are the cost object, the wages of all employees whose time cannot be identified with a specific product, represent indirect labour costs. Examples include the labour cost of staff employed in the maintenance and repair of production equipment and staff employed in the stores department. The cost of materials used to repair machinery cannot be identified with a specific product and can therefore be classified as indirect material costs. Examples of indirect expenses in manufacturing, service or a departmental store where products, the provision of a service or departments are the Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material cost objectives, include lighting and heating expenses and property taxes. These costs cannot be specifically identified with a particular product, service or department. The term ‘overheads ’ is widely used instead of indirect costs. In a manufacturing organization overhead costs are categorized as either manufacturing, administration and marketing (or selling) overheads. Manufacturing overheads include all the costs of manufacturing apart from direct labour and material costs. Administrative overheads consist of all costs associated with the general administration of the organization that cannot be assigned to either manufacturing, marketing and distribution overheads. Examples of administrative overheads include top-executive salaries, general accounting, secretarial and research and development costs. Those costs that are necessary to market and distribute a product or service are categorized as marketing (selling) costs, also known as order-getting and order-filling costs. Examples of marketing costs include advertising, sales personnel salaries/commissions, warehousing and delivery transportation costs. Figure 2.1 illustrates the various classifications of manufacturing and non-manufacturing costs. You will see from this figure that two further classifications of manufacturing costs are sometimes used. Prime cost consists of all direct manufacturing costs (i.e. it is the sum of direct material and direct labour costs). Conversion cost is the sum of direct labour and manufacturing overhead costs. It represents the cost of converting raw materials into finished products. FIGURE 2.1 Manufacturing and non-manufacturing costs Distinguishing between direct and indirect costs Sometimes, direct costs are treated as indirect because it is not cost effective to trace costs directly to the cost object. For example, the nails used to manufacture a particular desk can be identified specifically with the desk, but, because the cost is likely to be insignificant, the expense of tracing such items does not justify the possible benefits from calculating more accurate product costs. The distinction between direct and indirect costs also depends on the cost object. A cost can be treated as direct for one cost object but indirect in respect of another. For example, if the cost object is the cost of using different distribution channels, then the rental of warehouses and the salaries of storekeepers will be regarded as direct for each distribution channel. If, on the other hand, the cost object is the product, both the warehouse rental and the salaries of the storekeepers will be an indirect cost because these costs cannot be specifically identified with the product. Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material Assigning direct and indirect costs to cost objects Direct costs can be traced easily and accurately to a cost object. For example, where products are the cost object, direct materials and labour used can be physically identified with the different products that an organization produces. It is a relatively simple process to establish an information technology system that records the quantity and cost of direct labour and material resources used to produce specific products. In contrast, indirect costs cannot be traced to cost objects. Instead, an estimate must be made of the resources consumed by cost objects using cost allocations . A cost allocation is the process of assigning costs when a direct measure does not exist for the quantity of resources consumed by a particular cost object. Cost allocations involve the use of surrogate rather than direct measures. For example, consider an activity such as receiving incoming materials. Assuming that the cost of receiving materials is strongly influenced by the number of receipts, then costs can be allocated to products (i.e. the cost object) based on the number of material receipts each product requires. If 20 per cent of the total number of receipts for a period were required for a particular product then 20 per cent of the total costs of receiving incoming materials would be allocated to that product. If that product was discontinued, and not replaced, we would expect action to be taken to reduce the resources required for receiving materials by 20 per cent. In this example, the surrogate allocation measure is assumed to be a significant determinant of the cost of receiving incoming materials. The process of assigning indirect costs (overheads) and the accuracy of such assignments will be discussed in Chapter 3, but at this stage you should note that only direct costs can be accurately assigned to cost objects. Therefore, the more direct costs that can be traced to a cost object, the more accurate is the cost assignment. Period and Product Costs For profit measurement and inventory/stock valuation (i.e. the valuation of completed unsold products and partly completed products or services) purposes it is necessary to classify costs as either product costs or period costs. Product costs are those costs that are identified with goods purchased or produced for resale. In a manufacturing organization they are costs that are attached to the product and that are included in the inventory valuation for finished goods, or for partly completed goods (work in progress), until they are sold; they are then recorded as expenses and matched against sales for calculating profit. Period costs are those costs that are not included in the inventory valuation and as a result are treated as expenses in the period in which they are incurred. Hence no attempt is made to attach period costs to products for inventory valuation purposes. In a manufacturing organization all manufacturing costs are regarded as product costs and nonmanufacturing costs are regarded as period costs. The treatment of period and product costs for a manufacturing organization is illustrated in Figure 2.2. You will see that both product and period costs are eventually classified as expenses. The major difference is the point in time at which they are so classified. There are two reasons why non-manufacturing costs are treated as period costs and not included in the inventory valuation. First, inventories are assets (unsold production) and assets represent resources that have been acquired and that are expected to contribute to future revenue. Manufacturing costs incurred in making a product can be expected to generate future revenues to cover the cost of production. There is no guarantee, however, that non-manufacturing costs will generate future revenue, because they do not represent value added to any specific product. Therefore, they are not included in the inventory valuation. Second, many non-manufacturing costs Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material (e.g. distribution costs) are not incurred when the product is being stored. Hence it is inappropriate to include such costs within the inventory valuation. You should now refer to Example 2.1, which provides an illustration of the accounting treatment of period and product costs for income (profit) measurement purposes for a manufacturing organization. Do merchandising and service organizations need to distinguish between product and period costs? The answer is yes. Companies operating in the merchandising sector purchase goods for resale without changing their basic form. The cost of the goods purchased is regarded as a product cost and all other costs, such as administration and selling and distribution expenses, are considered to be period costs. Therefore, the cost of goods sold for a merchandising company would consist of the beginning merchandise inventory, plus the purchase of merchandise during the period, less the closing merchandise inventory. Note that the opening and closing inventories would be valued at the purchase cost of acquiring the inventories. Service organizations do not have beginning and closing finished goods inventories since it is not possible to store services but they may have work in progress (WIP). The cost FIGURE 2.2 Treatment of period and product costs EXAMPLE 2.1 The costs for Lee Manufacturing Company for period 1 are as follows: The accounting records indicate that 70 per cent of the above costs were assigned to the cost of the goods that were sold during the period, 10 per cent to work in progress and 20 per cent to finished goods inventory. Sales were £910 000 for the period. The opening and closing inventory of raw materials were identical and there were no opening WIP and finished goods inventories at the start of the period. The profit statement for period 1 will be as follows: Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material During the period 70 per cent of the production was sold and the remaining 30 per cent was produced for WIP and finished goods inventories. Seventy per cent of the product costs are therefore identified as an expense for the period and the remainder are included in the closing inventory valuations. If we assume that the closing inventory is sold in the next accounting period, the remaining 30 per cent of the product costs will become expenses in the next accounting period. However, all the period costs became an expense in this accounting period, because this is the period to which they relate. Note that only product costs form the basis for the calculation of cost of goods sold, and that period costs do not form part of this calculation. of direct materials (if applicable) plus direct labour and overheads that are assigned to cost objects (typically clients/customers) represent the product costs. All other costs represent the period costs. The beginning WIP, plus the cost assigned to the clients during the period, less the closing WIP represents the cost of the services sold for the period. This is equivalent to the cost of goods sold in a manufacturing organization. Cost Behaviour A knowledge of how costs and revenues will vary with different levels of activity (or volume) is essential for decision-making. Managers might require information in order to answer questions such as these: 1. How will costs and revenues change if activity is increased (or decreased) by 15 per cent? 2. What will be the impact on profits if we reduce selling price by 10 per cent based on the estimate that this will increase sales volume by 15 per cent? 3. How do the cost and revenues change for a university if the number of students is increased by 5 per cent? 4. How do costs and revenues of a hotel change if a room and meals are provided for two guests for a three-day stay? 5. How many tickets must be sold for a concert in order to break-even? Activity or volume may be measured in terms of units of production or sales, hours worked, miles travelled, patients seen, students enrolled or any other appropriate measure of the activity of an organization. The terms ‘variable’, ‘fixed’, ‘semi-variable’ and ‘semi-fixed’ have been traditionally used in the management accounting literature to describe how a cost reacts to changes in activity. Variable costs vary in direct proportion to the volume of activity; that is, doubling the level of activity will double the total variable cost. Consequently, total variable costs are linear and unit variable cost is Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material constant. Examples of variable costs in a manufacturing organization include direct materials, energy to operate the machines and sales commissions. Examples of variable costs in a merchandising company, such as a supermarket, include the purchase costs of all items that are sold. In a hospital, variable costs include the cost of drugs and meals which may be assumed to fluctuate with the number of patient days. Consider the example of a bicycle manufacturer who purchases component parts. Assume that the cost of purchasing two wheels for a particular bicycle is £10 per bicycle. Figure 2.3(a) illustrates the concept of variable costs in graphic form. You can see that as the number of units of output of bicycles increases or decreases, the total variable cost of wheels increases and decreases proportionately. Look at Figure 2.3(b). This diagram shows that variable cost per unit of output is constant even though total variable cost increases/decreases proportionately with changes in activity. Fixed costs remain constant over wide ranges of activity for a specified time period. They are not affected by changes in activity. Examples of fixed costs include depreciation of equipment, property taxes, insurance costs, supervisory salaries and leasing charges for cars used by the sales force. Figure 2.4 illustrates how total fixed costs and fixed cost per unit of activity react with changes in activity. FIGURE 2.3 Variable costs: (a) total; (b) unit FIGURE 2.4 Fixed costs: (a) total; (b) unit You will see from this diagram that total fixed costs are constant for all units of activity whereas unit fixed costs decrease proportionally with the level of activity. For example, if the total of the fixed costs is £5000 for a month the fixed costs per unit of activity will be as follows: Units produced Fixed cost per unit (£) 1 5000 Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material Units produced Fixed cost per unit (£) 10 500 100 50 1000 5 Because unit fixed costs are not constant per unit they must be interpreted with caution. For decision-making, it is better to work with total fixed costs rather than unit costs. The distinction between fixed and variable costs must be made relative to the time period under consideration. Over a period of several years, virtually all costs are variable. During such a long period of time, contraction in demand will be accompanied by reductions in virtually all categories of costs. For example, senior managers can be released, machinery need not be replaced and even buildings and land can be sold. Similarly, large expansions in activity will eventually cause all categories of costs to increase. Within shorter time periods, costs will be fixed or variable in relation to changes in activity. Spending on some fixed costs, such as direct labour and supervisory salaries, can be adjusted in the short term to reflect changes in activity. For example, if production activity declines significantly, then direct workers and supervisors might continue to be employed in the hope that the decline in demand will be temporary; but if there is no upsurge in demand then staff might eventually be made redundant. If, on the other hand, production capacity expands to some critical level, additional workers might be employed, but the process of recruiting such workers may take several months. Thus, within a short-term period, such as one year, labour costs can change in response to changes in demand in a manner similar to that depicted in Figure 2.5. Costs that behave in this manner are described as semi-fixed or step-fixed costs . The distinguishing feature of step-fixed costs is that within a given time period they are fixed within specified activity levels, but they eventually are subject to step increases or decreases by a constant amount at various critical activity levels. Our discussion so far has assumed a one-year time period. If we consider a shorter time period, such as one month, the step-fixed costs described in the previous paragraph will not occur, because it takes several months to respond to changes in activity and alter spending levels. Over very shortterm periods such as one month, spending on direct labour and supervisory salaries will be fixed in relation to changes in activity. Even though fixed costs are normally assumed to remain unchanged in response to changes in the level of activity in the short term, they may change in response to other factors. For example, if price levels increase then some fixed costs such as management salaries will increase. Before concluding our discussion of cost behaviour in relation to volume of activity, we must consider semi-variable costs (also known as mixed costs ). These include both a fixed and a variable component. If you refer to your telephone account for your land line you will probably find that it consists of a fixed component (the line rental) plus a variable component (the number of telephone calls made multiplied by the cost per call). Similarly, the office photocopying costs may consist of a fixed rental charge for the photocopiers plus a variable cost (the cost of the paper multiplied by the number of photocopies). The approaches that are used to separate semi-variable costs into their fixed and variable elements are explained in Chapter 23. Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material REAL WORLD VIEWS 2.1 Cost structures in the airline sector Many low-cost carriers such as easyJet and Ryanair regularly offer flights to customers at a very low price or even free. They continue to do this even during depressed economic times. Both continue to make good profits, with easyJet posting pre-tax profits of £54m in 2009, Ryanair €251m. More traditional carriers like Lufthansa and British Airways reported less positive results, with losses of €229m and £401m respectively. Why do low-cost carriers do better, even if they give away free seats from time to time? One reason is their cost structures. You might be thinking surely there is a cost of providing a seat to a passenger, so how can one be given away for free? To answer this, we need to consider the nature of costs at low-cost carriers. Most costs are fixed in nature. First, the aircraft cost (of about US$75m for a Boeing 737) is fixed. Second, the salaries of the pilot, first officer and cabin crew are also fixed. Third, maintenance costs would also be considered as a fixed cost. And what about the fuel cost? This is also treated as a fixed cost, since it is incurred once the aircraft flies. Thus, if one additional passenger flies with a low-cost carrier, the variable cost associated with this passenger is zero and hence tickets could be given for free. Traditional carriers like Lufthansa and British Airways have similar costs to the low-cost carriers – fuel, fleet purchase, maintenance and salaries, etc. These costs too are likely to be fixed. The difference is that these costs are probably at a higher level than low cost carriers. For example, low cost carriers typically use one model of aircraft which reduces maintenance costs and adds buying leverage. Salaries are also likely to be higher. Traditional airlines may have some variable costs, e.g. passenger meals. Thus, with overall higher costs, it is more difficult to reduce ticket prices or offer free seats. Of course, low-cost carriers do not give away all seats for free. They do, however, have sophisticated yield management systems to maximize the revenues from flights. This might mean that some customers pay a high price while others go free. Overall, they try to ensure all fixed costs are covered on every flight. Questions 1. Do you agree that the variable cost associated with a passenger can be zero? Can this be said for both low-cost and traditional carriers? 2. What options do more traditional carriers have to improve their fixed cost base? FIGURE 2.5 Step-fixed costs Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material Relevant and Irrelevant Costs and Revenues For decision-making, costs and revenues can be classified according to whether they are relevant to a particular decision. Relevant costs and revenues are those future costs and revenues that will be changed by a decision, whereas irrelevant costs and revenues are those that will not be affected by the decision. For example, if you are faced with a choice of making a journey using your own car or by public transport, the car tax and insurance costs are irrelevant, since they will remain the same whether or not you use your car for this journey. However, petrol costs for the car will differ depending on which alternative is chosen, and this cost will be relevant for decision-making. Let us now consider a further illustration of the classification of relevant and irrelevant costs. A company purchased raw materials for £100 per unit and then found that it was impossible to use them in future production or to sell them in their current state. A former customer is prepared to purchase a product that will require the use of all these materials, but he is not prepared to pay more than £250 per unit. The additional costs of converting these materials into the required product are £200. Should the company accept the order for £250? It might appear that the cost of the order is £300, consisting of £100 material cost and £200 conversion cost, but this is incorrect because the £100 material cost will remain the same whether the order is accepted or rejected. The material cost is therefore irrelevant for the decision. If the order is accepted the conversion costs will change by £200, and this conversion cost is a relevant cost. If we compare the revenue of £250 with the relevant cost for the order of £200, it means that the order should be accepted, assuming of course that no higher-priced orders can be obtained elsewhere. The following calculation shows that this is the correct decision. The net costs of the company are £50 less; in other words, the company is £50 better off as a result of accepting the order. This agrees with the £50 advantage which was suggested by the relevant cost method. In this illustration the sales revenue was relevant to the decision because future revenue changed depending on which alternative was selected. However, in some circumstances, sales revenue may also be irrelevant for decision-making. Consider a situation where a company can meet its sales demand by purchasing either machine A or machine B. The output of both machines is identical, but the operating costs and purchase costs of the machines are different. In this situation the sales revenue will remain unchanged irrespective of which machine is purchased (assuming of course that the quality of output is identical for both machines). Consequently, sales revenue is irrelevant for this decision; the relevant items are the operating costs and the cost of the machines. We have now established an important principle regarding the classification of cost and revenues for decisionmaking; namely, that in the short-term not all costs and revenues are relevant for decision-making. Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material Avoidable and Unavoidable Costs Sometimes the terms avoidable and unavoidable costs are used instead of relevant and irrelevant cost. Avoidable costs are those costs that may be saved by not adopting a given alternative, whereas unavoidable costs cannot be saved. Only avoidable costs are relevant for decision-making purposes. In the example that we used to illustrate relevant and irrelevant costs, the material costs of £100 are unavoidable and irrelevant, but the conversion costs of £200 are avoidable and hence relevant. The decision rule is to accept those alternatives that generate revenues in excess of the avoidable costs. Sunk Costs These costs are the cost of resources already acquired where the total will be unaffected by the choice between various alternatives. They are costs that have been created by a decision made in the past and that cannot be changed by any decision that will be made in the future. The expenditure of £100 on materials that were no longer required, referred to in the preceding section, is an example of a sunk cost . Similarly, the written down values of assets previously purchased are sunk costs. For example, if equipment was purchased four years ago for £100 000 with an expected life of five years and nil scrap value, then the written down value will be £20 000 if straight line depreciation is used. This written down value will have to be written off, no matter what possible alternative future action might be chosen. If the equipment was scrapped, the £20 000 would be written off; if the equipment was used for productive purposes, the £20 000 would still have to be written off. This cost cannot be changed by any future decision and is therefore classified as a sunk cost. Sunk costs are irrelevant for decision-making, but not all irrelevant costs are sunk costs. For example, two alternative production methods may involve identical direct material expenditure. The direct material cost is irrelevant because it will remain the same whichever alternative is chosen, but the material cost is not a sunk cost since it will be incurred in the future. Opportunity Costs An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of one course of action requires that an alternative course of action is given up. Consider the situation where a student is contemplating taking a gap year overseas after completing his studies. Assume that the student has an offer of a job upon completion of his studies. The lost salary is an opportunity cost of choosing the gap year that must be taken into account when considering the financial implications of the decision. For a further illustration of an opportunity cost you should now look at Example 2.2. REAL WORLD VIEWS 2.2 Sunk costs – government expenditure Governments worldwide spend vast amounts of money on capital projects such as road and rail infrastructure, schools, hospitals, community projects and even defence. While the vast majority of these projects are well planned, have detailed objectives and are usually well costed, from time to time, some projects are abandoned before completion. This creates substantial sunk costs for government departments, as portrayed in the two following examples. In the US, the Department of Homeland Security spent $1billion between 2005 and 2010 to develop a networked suite of electronic sensors along its northern and southern borders. The project was frozen in March 2010, after only 53 of 6000 miles were complete. In Spring 2009, the Irish government disposed of Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material electronic voting machines which had been purchased at a cost of €51m several years earlier. The machines were only used once on a trial basis and the cost mentioned did not include the costs of storage for more than two years. Questions 1. Why are each of the above considered sunk costs? 2. How could such costs be avoided? EXAMPLE 2.2 A company has an opportunity to obtain a contract for the production of a special component. This component will require 100 hours of processing on machine X. Machine X is working at full capacity on the production of product A, and the only way in which the contract can be fulfilled is by reducing the output of product A. This will result in a lost profit contribution of £200. The contract will also result in additional variable costs of £1000. If the company takes on the contract, it will sacrifice a profit contribution of £200 from the lost output of product A. This represents an opportunity cost, and should be included as part of the cost when negotiating for the contract. The contract price should at least cover the additional costs of £1000 plus the £200 opportunity cost to ensure that the company will be better off in the short term by accepting the contract. Opportunity costs cannot normally be recorded in the accounting system since they do not involve cash outlays. They also only apply to the use of scarce resources. Where resources are not scarce, no sacrifice exists from using these resources. In Example 2.2 if machine X was operating at 80 per cent of its potential capacity and the decision to accept the contract would not have resulted in reduced production of product A, there would have been no loss of revenue, and the opportunity cost would be zero. Opportunity costs are of vital importance for decision-making. If no alternative use of resources exists then the opportunity cost is zero, but if resources have an alternative use, and are scarce, then an opportunity cost does exist. REAL WORLD VIEWS 2.3 Rising food prices and opportunity costs Food prices have been rising in the past decade or so. In 2008, many countries around the world saw rioters protest in anger against the rising cost of basic foods stuffs. Poorer countries were particularly affected. What are the root causes of the price rises? To some extent, foods producers are replacing food crops with crops used for bio-fuel production. While an immediate economic opportunity cost is not apparent in the case of bio-fuels, there is an obvious social opportunity cost as bio-fuel production increases. Another reason for the rising prices is the increasing amount of money in many developed economies as governments print money to help economic recovery. As the general economic situation in many developed countries deteriorated from 2008, investors have turned to commodities, including foodstuffs, as a hedge investment. This, coupled with lower interest rates which reduces the opportunity costs of hoarding commodities, has also contributed to increasing prices. Questions Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material 1. What ‘social’ opportunity costs might result as more land is used for bio-fuels? 2. How would food growers use opportunity costs in decision-making? Assignment of Direct and Indirect Costs Costs that are assigned to cost objects can be divided into two categories – direct costs and indirect costs. Sometimes the term overheads is used instead of indirect costs. Direct costs can be accurately traced to cost objects because they can be specifically and exclusively traced to a particular cost object whereas indirect costs cannot. Where a cost can be directly assigned to a cost object the term direct cost tracing is used. In contrast, direct cost tracing cannot be applied to indirect costs because they are usually common to several cost objects. Indirect costs are therefore assigned to cost objects using cost allocations. A cost allocation is the process of assigning costs when the quantity of resources consumed by a particular cost object cannot be directly measured. Cost allocations involve the use of surrogate rather than direct measures. For example, consider an activity such as receiving incoming materials. Assuming that the cost of receiving materials is strongly influenced by the number of receipts, then costs can be allocated to products (i.e. the cost object) based on the number of material receipts each product requires. The basis that is used to allocate costs to cost objects (i.e. the number of material receipts in our example) is called an allocation base or cost driver . If 20 per cent of the total number of receipts for a period were required for a particular product then 20 per cent of the total costs of receiving incoming materials would be allocated to that product. Assuming that the product was discontinued, and not replaced, we would expect action to be taken to reduce the resources required for receiving materials by 20 per cent. In the above illustration the allocation base is assumed to be a significant determinant of the cost of receiving incoming materials. Where allocation bases are significant determinants the terms causeand-effect allocations or driver tracing are used. Where a cost allocation base is used that is not a significant determinant of its cost, the term arbitrary allocation is used. An example of an arbitrary allocation would be if direct labour hours were used as the allocation base to allocate the costs of materials receiving. If a labour intensive product required a large proportion of direct labour hours (say 30 per cent) but few material receipts, it would be allocated with a large proportion of the costs of material receiving. The allocation would be an inaccurate assignment of the resources consumed by the product. Furthermore, if the product were discontinued, and not replaced, the cost of the material receiving activity would not decline by 30 per cent because the allocation base is not a significant determinant of the costs of the materials receiving activity. Arbitrary allocations are therefore likely to result in inaccurate allocations of indirect costs to cost objects. Figure 3.1 provides a summary of the three methods of assigning costs to cost objects. You can see that direct costs are assigned to cost objects using direct cost tracing whereas indirect costs are assigned using either cause-and-effect or arbitrary cost allocations. For accurate assignment of indirect costs to cost objects, cause-and-effect allocations should be used. Two types of systems can be used to assign costs to cost objects. They are direct and absorption costing systems. A direct costing system (also known as a marginal or variable costing system) assigns only direct costs to cost objects whereas an absorption costing system assigns both direct and indirect costs to cost objectives. Absorption costing systems can be sub-divided into traditional costing systems and activity-based-costing (ABC) systems. Traditional costing systems were developed in the early 1900s and are still widely used today. They tend to use arbitrary cost allocations. ABC systems only emerged in the late 1980s. One of the major aims of ABC systems is to use mainly cause-and-effect cost Downloaded by: SUCCESS01TUTOR | Distribution of this document is illegal S - The Marketplace to Buy and Sell your Study Material allocations and avoid arbitrary allocations. Both cost systems adopt identical approaches to assigning direct costs to cost objects. We shall look at traditional and ABC systems in more detail later in the chapter. FIGURE 3.1 Cost assignment methods